Recent program manager technical assistance from the Office of Chief Counsel (PMTA-2009-035) provides a detailed analysis of the IRS’s position on dealing with income and employment tax consequences, as well as appropriate reporting, of employment-related judgment or settlement payments. The PMTA goes on to state that determining the correct treatment of employment-related settlement payments is a four-step process:
- Determine the character of the payment and the nature of the claim that gave rise to the payment;
- Determine whether the payment constitutes an item of gross income;
- Determine whether the payment is wages for employment tax purposes; and
- Determine the appropriate reporting for the payment and any attorneys’ fees (Form 1099 or Form W-2).
This item highlights the PMTA’s key areas and points out important concepts.
Character of the Payment and Nature of the Claim
There are numerous types of settlement payments or awards that an individual may receive in connection with an employment-related dispute. Some of these payment types include severance pay, back pay, front pay, compensatory damages, consequential damages, and punitive damages. In addition, depending on the specific set of facts and circumstances, the nature of the claim can be tied back into a federal provision or statute. Some of the most widely known of these include title VII of the Civil Rights Act of 1964, the Back Pay Act, the Age Discrimination in Employment Act of 1967, and the Fair Labor Standards Act of 1938.
Taxable or Not
The first step in deciding whether a payment or settlement is taxable can be found in Sec. 104. Sec. 104(a)(2) states that “gross income does not include the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness.” While this definition might seem clear and concise, there are several things to point out.
First, in order to comply with the regulations promulgated under Sec. 104, payments of damages must have been received either through prosecution of a legal suit or in a settlement agreement in lieu of prosecution of a suit. A general release of claims against an employer under a termination plan or severance package is not a claim under Sec. 104 and thus is taxable. Second, emotional distress cannot be treated as a physical injury or physical sickness, so payments in connection with an emotional distress injury do not qualify for a Sec. 104(a)(2) exclusion. Finally, the claim must be for a tort or tort-like injury to be excluded under Sec. 104(a)(2).
Employment Tax Treatment (FICA and Income Tax Withholding)
Under Sec. 3101, FICA tax is owed on all payments made by an employer to its employees. Under Sec. 3402(a), an employer is required to withhold income tax on all wages paid to its employees. However, if amounts are not income and fall within Sec. 104(a)(2), they are not wages for FICA and income tax purposes.
Severance pay is a payment made by an employer to an employee upon the involuntary termination of employment and is taxable to the recipient. Severance pay, like the pay it replaces, is considered wages for FICA and income tax withholding purposes.
Back pay is compensation paid to an individual to compensate him or her for pay he or she would have received up to the time of settlement or court award and for the employer’s wrongful conduct. It can be awarded to an employee if he or she is illegally terminated by an employer or to an applicant for employment who is not hired for illegal reasons. The IRS and the courts agree that back pay is wages for FICA and income tax withholding purposes, except if the back pay is received because of a personal physical injury or physical sickness.
The PMTA reiterates the IRS’s rulings position that back pay awarded for an illegal refusal to hire is considered wages for federal employment tax purposes, but it also acknowledges Newhouse v. McCormick & Co., 157 F.3d 582 (8th Cir. 1998). In this case, applicable in the seven states of the Eighth Circuit (Minnesota, North Dakota, South Dakota, Iowa, Nebraska, Missouri, and Arkansas), the court held that FICA tax and income tax withholdings do not apply unless there was an actual employer-employee relationship.
Front pay is paid to an individual to compensate for pay he or she would have received after the settlement date or court award and for the employer’s wrongful conduct. The PMTA indicates that the IRS’s position is that front pay is considered wages for FICA. It does, however, also note Dotson, 87 F.3d 682 (5th Cir. 1996). In this case, which applies only in the three states of the Fifth Circuit (Texas, Louisiana, and Mississippi), the court concluded that only the back pay portion of a settlement was wages for FICA tax purposes.
Attorneys’ Fees and Interest and the Allocation of Payments
Another important question to consider is whether payments received for attorneys’ fees and interest should be included in gross income and considered wages for federal employment tax purposes. The IRS originally discussed this in Rev. Rul. 80-364 and reiterated it in the PMTA.
If the courts are able to break out the award into distinct components, the attorneys’ fees and interest, while still includible in gross income, will not be subject to employment taxes. If not, then the full amount will be considered wages. The PMTA urges courts to break down the amount of the award into its respective elements, such as back pay, emotional distress damages, attorneys’ fees, etc., which would make it much easier to determine which portion constitutes wages.
It is important that tax preparers understand the rules regarding what is includible in gross income, what is considered wages and subject to FICA and income tax withholding, and the respective reporting requirements for each type of judgment or settlement. PMTA 2009-035 goes into great detail discussing the above rules and even provides a four-page chart summarizing the findings, so practitioners should be able to use it to provide assistance and reliable, sound advice to their clients in these areas.
Mark Cook is a partner at Singer Lewak LLP in Irvine, CA.
Unless otherwise noted, contributors are members of or associated with Singer Lewak LLP.The editor would like to offer a special thanks to Jennifer Allison, J.D., for her assistance with this column.
For additional information about these items, contact Mr. Cook at (949) 261-8600, ext. 2143, or firstname.lastname@example.org.